The (Option) Price is Right

In this lesson, we want to give a brief overview on how options are priced.

OPTION CONTRACTS

When you decide to purchase options, the first thing you need to realize is that you can’t purchase a single stock option — you can only purchase option contracts.

Each option contract consist of 100 options. The price listed on an options chain will only provide the price of a single option, and you will need to multiply that single price by 100 when you decide to buy a contract.

OPTION PRICING

As we discussed in the previous section, when you purchase an option you are not buying the actual stock itself, but simply the right to buy or sell the stock. As such, options prices are substantially lower than the price of the stock itself.

There are a number of factors that are used to determine the value of the option. This includes the following:

1. The intrinsic value of the underlying stock. Obviously the deeper in-the-money the option is, the more expensive it is.

2. The volatility of the stock. The more a stock swings up and down in a short period of time, the more volatile it is. The greater the volatility, then, the higher the option price.

3. The amount of time purchased before the stock expires. For example, if you purchased an option that expires in two months, it would cost more than an option that expires in one month.

4. The dividend paid by the company is a important factor.

5. The interest rate (three-month T-Bond) also plays in the pricing of an option.

BID/ASK SPREADS

For really short-term option plays, you must choose options with small spreads between the bid and the ask. When you decide to buy an option, you will be given two prices — the “Bid” and the “Ask” price.

The Bid, which is the lower of the two prices, is the price you will receive per option if you decide to sell your contract at that particular moment.

The “Ask” is the price you will have to pay per option if you decide to buy the option on that stock.

Note: As mentioned previously, this is only the price per option, you will have to multiply that number by 100 when you buy an option contract.

There are numerous options plays available to an option trader. These include Covered Calls, Covered Puts, Bull-Call Credit, Bear-Put Credit, Straddles, Strangles, Collar, LEAPS, etc. Education is essential and understanding the risk factors and rewards of options is of most importance.

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